Value Delusions and Strategic Thinking

One of my great mentors in life was my partner, Doug in a previous investment partnership. His goal in “managing” this business was to ensure that all of us had some time on our hands. Like most young people who were trying to make partnership, I was working my butt off attempting to bring in a raft of new investment ideas. With a universe of securities that literally covered the earth outside of Canada, it was tempting to build a shopping list of value oriented ideas. Screening for low P/E’s, low P/BV’s, low P/CF, high ROE, high ROIC etcetera seemed like the intelligent thing to do. Yet, it always seemed to me that much of what I was doing was far too obvious, far too rule of thumb, far too plug-and-play investing. The discipline itself was helpful in that it kept me from doing too many stupid things (Doug may have felt otherwise.) But what seemed obvious and rudimentary didn’t really involve much thinking. It was merely a cookbook approach. I was successful in being asked to join the investment partnership, but I was more of a proponent of disciplined analytics than a critical thinker or outstanding investor.

There is great wisdom in backing away from the task at hand and to re-assess. Much like the old IBM mantra of “THINK,” it is important for us to chill, to breathe and to think. One of the worst mistakes we make in investing is to do something without thinking it through entirely. Doug’s contribution to my becoming an investor was his insistence that I take some time to think things through. Trading requires instant analysis and can be very instinctive and gut-based. It takes cognition to invest. That takes time away from a computer screen, away from a phone, and away from CNBC.

Great investors have strong analytical disciplines that are second nature. But much more important than that is an ability to ask the right questions. Investing involves much more than the ability to recite endless data about a company’s history. It is the ability to understand why a business is successful or otherwise. It is the ability to distinguish facts from opinion and even more important than that, is the ability to avoid the “halo effect.” Rather than succumb to hyperbole and hype found in much “research,” great investors attempt to improve their powers of critical thinking. Cheapness in and of itself can frequently be a value delusion...presents excellent “value,” but at best, likely to stay there.

Most of us spend insufficient time thinking about the underlying keys to a company’s performance. The better blogs speak to value and the best refer to competitive advantage. Unfortunately, at least in my view, most of investment blogspace is completely irrelevant to understanding a business.

There is far more to successful investing than following a specific series of steps. In a recent McKinsey Quarterly article, Phil Rosenzweig, a professor of strategy at IMD in Switzerland outlines his views on business strategy and the halo effect. A great investor should think like a great business strategist in my view.

“If success could be reduced to a formula, companies would not need strategic thinking but could rely on administrators to tick the right boxes and ensure that formulas were followed with precision.” Rosenzweig highlights the fundamental uncertainty in the business world. None of us can accurately predict a customer’s response to a new product or service with 100% accuracy. None of us can predict the actions of an old or new competitor to our actions. Consequently, all of us need to approach investment or strategic problems as interlocking probabilities.

Charlie Munger has spoken in awe-struck tones about Buffett’s ability to “think in decision trees.” As investors we can improve the odds by considering these kinds of external factors...industry forces, customer trends, and the nature of competition. Our internal analysis should focus on the capabilities and resources of the business as well as its risk preferences. I think we make a great mistake when we believe we understand the value of a business in absolute terms without considering the odds, chances, and trade-offs.

Another great Rosenzweig observation, “A business’s performance is fundamentally relative, not absolute. Success and failure depend not only on a company’s actions but also on those of its rivals. A company can improve its operations in many ways-better quality, lower cost, faster throughput time, superior asset management, and more-but if rivals improve at a faster rate, its performance may suffer.”

Isn’t this the issue with US automakers? Despite much improved product quality, improved safety, better inventory management, etc, the more that the Big 3 moved ahead, Japanese and Korean manufacturers moved ahead faster. In absolute measures of productivity and assessment of product, the Big 3 made enormous absolute improvements. But in a relative sense, the “behinder” they got. Little wonder that the absolute performance provided their shareholders little comfort.

Value investing is based on a premise that one is buying assets at a discount to their intrinsic value, the great teaching of Benjamin Graham. But the determination of intrinsic value is premised on understanding competitive advantage, the competitive landscape, understanding the odds of success, and determining the probabilities of these interlinked outcomes. These complex judgments are pivotal for managements to build a successful enterprise but are also necessary for investors to build successful portfolios.

My worst mistakes in investing have come from not fully appreciating the competitive threats to a business and in buying “absolute” rather than “genuine” value. Absolute value often is termed value trap...one-puff cigars. Few businesses have unlocked the secrets of sustained greatness. Scrutinize your holdings carefully to understand the competitive threats that are ever-present. Critical and strategic thinking will improve your portfolio performance.